BIS study finds banks use CDS for capital requirement adjustments
A new Bank for International Settlements (BIS) study finds that banks significantly increase their use of credit default swaps (CDS) to hedge loans when countercyclical capital buffer (CCyB) rates rise. This strategy allows banks to adjust to higher capital requirements without necessarily reducing lending.
Hedging capital with credit default swaps
The study reveals that banks significantly increase their use of credit default swaps (CDS) to hedge loans in countries where countercyclical capital buffer (CCyB) rates rise.
Specifically, a 1 percentage point increase in the CCyB reduces the uninsured share of a loan by approximately 53 percentage points.
This response is most pronounced among banks with the highest exposure to the affected country.
The research, which links EU trade-repository CDS data to syndicated loans from November 2017 to April 2024, highlights that this hedging behavior allows banks to reduce risk-weighted assets (RWA) without necessarily cutting lending.
This mechanism potentially mitigates the impact of tighter capital requirements on credit availability.
Beyond traditional capital adjustments
Traditionally, banks respond to tighter capital regulations by either raising new equity or reducing their lending activities, thereby cutting risk-weighted assets.
This paper, however, presents credit default swaps as an alternative strategy for managing capital constraints.
By leveraging CDS markets, banks can transfer credit risk, which allows them to meet regulatory demands while potentially maintaining their credit supply.
This approach moves beyond the conventional understanding of how banks accommodate higher capital requirements, offering new insights into the interaction between modern financial markets and macroprudential policy tools like the CCyB.
A double-edged buffer
While seemingly beneficial for credit supply, these findings raise critical questions about the ultimate effectiveness of countercyclical capital buffers.
Banks' use of derivatives to optimize risk transfers could inadvertently circumvent the intended constraints on risk-taking.
This suggests macroprudential tools might require recalibration to fully achieve their stability objectives.